‘Undervalued’ Capital Notes

Someone I know recently went to an investment course conducted at an evening college.

The presenter pointed out a number of ASX-listed debt securities (often called Capital Notes) that are trading below their Net Present Value (NPV), by between 5-12%. I was asked for my opinion.

For those that don’t know what these are, these are much like bonds – they are normally issued by public companies, e.g. banks/insurance companies to the public in order to borrow large amounts of money, e.g. to facilitate expansion.

Each bond/note that is issued has a given face value, e.g. $100. They pay a certain interest rate periodically for the duration of their lifetime, i.e. 8% per annum for 10 years,  after which the bond matures and the face value is paid back.

The underlying value of a bond at a given point in time is the Net Present Value (NPV) of its future cashflows. We take each pending payment (interest income and the face value paid upon maturity), discount them back to today’s dollars using current market interest rates and then sum them together to produce the NPV.

This is why when the RBA raises interest rates, the value of bonds falls, and if interest rates fall, the bonds rise.

OK, here’s a far better written explanation from Investopedia:

http://www.investopedia.com/university/advancedbond/advancedbond2.asp

OK, so does this mean that if a bond/note is currently being traded below its NPV, that it is a risk-free investment? The answer, as always, is in the fine print.

I checked out a couple of product disclosure statements. I noted the following:

  • One product gave the company the right to indefinitely delay maturity of the bond.
  • One product stated that in the event of the company getting into financial trouble, note holders would rank above shareholders, but below other debtors.
  • Some have other conditions that make returns dependent on the movements of the company’s normal shares.

Such conditions may potentially pose risks and should be factored into your investment decision.

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